I dreamed a thousand new paths…I woke and walked my old one – Chinese proverb[i]
The last week has seen the biggest drop of the year in global equities as two main macro drivers of equity prices for the past two years – trade disputes with China and Federal Reserve policy – have been the background for the latest round of market angst.
Since the G20 meeting in June and a truce in the US-China trade war, there was hope that renewed talks could avoid an escalation in tariffs or other penalties. Last week’s talks in Shanghai did not produce any progress, and the Administration decided to implement a 10% tariff on $300 billion of consumer-oriented goods that had yet to be subject to tariffs[ii]. In response, this week the Chinese have allowed their currency to fall to levels they had previously maintained and have halted purchases of US agricultural products. [iii]
The weaker currency can offset the tariffs on exports to the US, but there are additional impacts. US goods will be less price competitive against Chinese products in third party countries, and capital flight out of China will likely accelerate, which would slow Chinese GDP. Meanwhile, the large and steady protests in Hong Kong are increasingly having an impact on economic activity there.
The Fed’s Interest Rate Cut
Last week the Federal Reserve announced a quarter point cut in the Federal Funds rate, taking back what many believe was a mistake increase back in December. Fed Chair Powell upset markets in his press conference as he implied the Fed may not implement as many future cuts as markets had hoped.[iv] Since then other central banks have also cut interest rates.[v]
As both longer- and shorter-term interest rates fall, equity markets become a more competitive alternative to fixed income. With the dividend yield on the S&P 500 at 2% and the yield on the ten-year treasury in the 1.7% range, equities are not only a source of long-term capital growth, they are also an important source of current income in portfolios.[vi] Price-to-earnings ratios and other valuation metrics continue to be well within historical norms, especially given the low level of interest rates.[vii] We are winding up the second quarter earnings reporting season, and it has been reasonably good, with 77% of S&P 500 companies reporting earnings ahead of expectations, above the 75% 12-quarter average.[viii]
Where do we go from here?
Earnings growth is expected to pick by the fourth quarter and into 2020. Will the increased tensions with China meaningfully lower those expectations, or will lower interest rates sufficiently offset that China impact? That’s what traders are speculating on every trading day. Trying to tactically adjust in these moments of heightened volatility over trade and interest rates is futile. Instead we are long-term investors who maintain a disciplined, strategic approach. To the extent that portfolio allocations call for rebalancing, we will not hesitate to bring portfolios back into policy targets.
The Bottom Line
Our equity portfolios are invested across thousands of businesses across every industry across the globe. Over time, on balance, those businesses will grow their sales and profits, but historically that growth is subject to up and down economic cycles. Profit growth was very strong in 2017 and 2018. For that growth to slow in 2019 and into 2020 is not a shocker. At Team Hewins, we will stick to our core investment principles – diversification, discipline, simple solutions, low costs, and tax efficiency. Why? As our experience for over two decades indicates, it works! We are back in a period of bigger market swings similar to but still not as heightened as last December or February 2018. So, we have recently been here. We withstood those periods and will withstand this one too.
In the meantime, the decline in rates means that bonds have done well as equities have pulled back. They are doing their job—diversifying equity exposure and providing stability in the portfolio.
Please don’t hesitate to reach out to your advisor to discuss your program and the current market environment.
Enjoy the rest of your summer,
John M. Bussel
Principal, Chief Investment Officer
[i] Bill. “The Best of the Chinese Proverbs (Inspirational Quotations #362).” Right Attitudes, 31 Jan. 2017, www.rightattitudes.com/2011/02/03/chinese-proverbs-inspirational-quotations-362/.
[ii] YunLi626. “Trump Says US Will Impose 10% Tariffs on Another $300 Billion of Chinese Goods Starting Sept. 1.” CNBC, CNBC, 1 Aug. 2019, www.cnbc.com/2019/08/01/trump-says-us-will-impose-10percent-tariffs-on-300-billion-of-chinese-goods-starting-september-1.html.
[iii] EustanceHuang. “China’s Yuan Just Weakened to an Important Level. One Analyst Says It’s ‘Retaliation’ for Tariffs.” CNBC, CNBC, 5 Aug. 2019, www.cnbc.com/2019/08/05/chinese-yuan-moves-against-the-dollar-amid-us-china-trade-turmoil.html.
[iv] Timiraos, Nick. “Fed Cuts Rates by a Quarter Point in Precautionary Move.” The Wall Street Journal, Dow Jones & Company, 31 July 2019, www.wsj.com/articles/fed-cuts-rates-by-a-quarter-point-ends-portfolio-runoff-11564596200?mod=article_inline.
[v]Blackstone, Brian. “Trio of Central Banks Surprise Markets With Aggressive Rate Cuts.” The Wall Street Journal, Dow Jones & Company, 7 Aug. 2019, www.wsj.com/articles/trio-of-central-banks-surprises-markets-with-rate-cuts-11565175324.
[vii]Stock Market Briefing: S&P 500 Sectors & Industries Forward P/Es – PDF download https://www.yardeni.com/pub/mktbriefsppesecind.pdf
[viii] Mian, Sheraz. “The Earnings Picture Is Good Enough.” Zacks Investment Research, Zacks Investment Research, 7 Aug. 2019, www.zacks.com/commentary/458082/the-earnings-picture-is-good-enough?art_rec=home-home-earnings_analysis-ID01-txt-458082.
Team Hewins, LLC (“Team Hewins”) is an SEC registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. The information contained within this letter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. Past performance is not a guarantee of future returns. It should not be assumed that diversification protects a portfolio from loss or that the diversification in a portfolio will produce profitable results. The opinions stated herein are as of the date of this letter and are subject to change. The information contained within this letter is compiled from sources Team Hewins believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. For detailed information about our services and fees, please read our Form ADV Part 2A, which can be found at https://www.advisorinfo.sec.gov or you can call us and request a copy at (650) 620-3040.